Here are 7 essential criteria to identify undervalued stocks

When you buy a stock, you want to evaluate if its current price
is higher or lower than what it’s worth over the long term.
All sorts of events which have nothing to do with a stock’s
intrinsic value can affect its price, and
frequently this means that stocks are undervalued. For
example, Steve Symington argues that CenturyLink
is currently undervalued because investors haven’t yet accounted
for the long-term impact of its imminent merger with Level 3
Communications, which, he predicts, “could be a
fantastic driver of shareholder value.”

WHAT IS VALUE INVESTING?

“Value investing consists of investing in stocks trading at
prices below their intrinsic value. Value investors, therefore,
are essentially buying stocks at a discount to what they
believe they are worth, in hopes these investments will
eventually rise to reflect their intrinsic value.”

Value investors understand the
market often undervalues stocks based on news and events
which have little if anything to do with the long-term
fundamentals of those stocks. They apply specific
strategies to identify and invest in such stocks.

Ward recommends looking at stocks with a quality rating that is
average or better. Like Graham, he advises using Standard
& Poor’s rating system to find out stocks with an
S&P Earnings and Dividend Rating of B or better (on the
S&P scale of D to A+). To be safe, Ward says, it’s best
to choose stocks with quality ratings of at least B+.

2. Debt to current asset ratio

In value investing, it’s important to select companies with a low
debt load (this is especially important when lending is tight and
the economy is relatively weak). You should select
companies with a total debt to current asset ratio of 1.10 or
less. There are a number of services which supply total
debt to current asset ratios, including Standard & Poor’s and
Value Line.

3. Current ratio

The current ratio provides a good indication of how much cash and
current assets a company has—something that demonstrates they can
weather unanticipated declines in the economy. You should
buy stocks from companies with a current ratio of 1.50 or higher.

4. Positive earnings per share growth

To avoid unnecessary risk, value investors look for companies with
positive earnings per share growth. Specifically, you
should examine this metric over the past 5 years, and prioritize
companies where earnings increase over that time period.
Above all, avoid companies which posted deficits in any of the
last 5 years.

5. Price to earnings per share (P/E) ratio

You should select stocks with low P/E ratios, preferably 9.0 or
less. These are companies that are selling at bargain
prices (in other words, they’re undervalued). This
criterion eliminates high growth companies, which, according to
Ward, should be assessed using growth investing techniques.

6. Price to book value (P/BV)

P/E values are helpful, but they should be viewed
contextually. Specifically, you also need to consider the
current price of a stock in relation to its book value, which gives you a strong
indication of the underlying value of a company. As a
value investor, you want to invest in stocks which are selling
below their book value. The P/BV ratio is calculated by
dividing the current price by the book value per share.

7. Dividends

You should look at companies which are paying steady
dividends. Undervalued stocks eventually tick higher as
other investors figure out they’re worth more than what their
price suggests, but that process can take time. If the
company is paying dividends, you can afford to be patient as the
stock moves from undervalued to overvalued.

CONCLUSION

The criteria which Ward uses provide a useful strategy to
identify and invest in undervalued stocks—but it’s also important
to understand the underlying conditions within a company which
are the cause of its bargain price. For example, a stock
could be undervalued because the company is in an industry which
is dying.

If a company is experiencing a problem which is the root cause of
its undervaluation, you need to know if that problem is short or
long-term, and whether the company’s management has a sound plan
to address it.